Largest banks testing climate risks across loans

The prudential regulator has published an information paper outlining the purpose, design and scope of the Climate Vulnerability Assessment (CVA) that is underway with the big four banks and Macquarie.

The test has been measuring the impact on each of the institutions and the financial system of two different future scenarios for how climate change may unfold.

The first scenario of the two from the international Network for Greening the Financial System, has explored a world that takes action, with higher transition risks due to delayed or differing emissions reduction pathways across countries and sectors.

The second assumes limited further action on climate change globally, failing to prevent significant global warming and resulting in more severe physical risks.

The CVA has adjusted the climate scenarios to Australian conditions, with APRA stating the test is meant to provide insights into the potential financial exposure of institutions, the financial systems and economy to the physical and transition risks of climate change.

It has three key objectives: to assess potential financial exposure to financial risk, to understand how banks may adjust their business models and implement management actions in response to different scenarios and to foster improvement in climate risk management capabilities.

The banks will be required to assess their residential mortgages, corporate and business lending exposures, which account for around three-quarters of their Australian lending exposures.

Across each portfolio, they will need to explore transition risk, potential impacts from changes in economic activity; and physical risk, stemming from climate or extreme weather events.

In business lending, the banks will have to assess physical risk across agriculture and non-agriculture loans, with details required on three commodities: beef cattle, dairy and grain.

The CVA kicked off in June, with the five banks due to submit their first analysis towards the end of the year. APRA is expecting to publish aggregated results and findings early next year.

APRA chair Wayne Byres commented the CVA will help regulators better understand the risks and how financial institutions plan to respond.

“APRA began the CVA program in the banking sector due to its centrality to the Australian financial system, as well as the potential impacts across the portfolios, from household mortgages to business exposures,” Mr Byres said.

“The results should help the boards and management of participating institutions to understand and proactively address any identified risks, as well as capitalise on new opportunities.”

The CVA was designed in consultation with the participating banks and the Australian Banking Association, as well as other agencies on the Council of Financial Regulators.

The information paper also compares and contrasts the CVA with similar assessments from other central banks and regulators, including the European Central Bank (ECB), the Bank of England and Banque de France (BdF).

APRA and the English regulators have included mortgages in their tests, while the ECB has only looked at business lending and BdF has only included business lending exposures from a selection of sectors.

“Climate change is a global challenge and is driving major policy responses and investment decisions around the world. These will have consequences for Australian companies, presenting both risks and opportunities,” Mr Byres said.

“Understanding how, where and over what timeframe these risks will play out is a test for financial regulators, as much as it is for institutions. In response, APRA will continue its collaboration with international peers to gain insights we can use to refine and strengthen our understanding, and ensure Australian financial institutions are appropriately managing those risks.”